Underwriter

Underwriters are the large financial service institutions (bank, syndicate, investment house), mainly acting as intermediates between customers and public. They provide a wide range of products, which cover from corporate bonds to commercial papers.

Once a borrower wishes to get a loan, it is the underwriter’s role to make detailed credit analysis before its granting based on credit information such as salary and employment history.

Habib and Ljungqvist (2001) argue that issuers do not choose underwriters randomly, nor do banks randomly agree which companies to take public. Optimizing agents presumably make the choices we actually observe.

Moreover, in IPO cases, issuers likely base their choices, at least in part, on the underpricing they expect to suffer. This leads to endogeneity bias when regressing initial returns on underwriter choice.

For instance, a company that is straightforward to value will expect low underpricing, and so has little to gain from the greater certification ability of a prestigious underwriter. A high-risk issuer, on the other hand, will expect substantial underpricing in the absence of a prestigious underwriter.

Carter and Manaster (1990) provide a ranking of underwriters based on their position in the financial press that follows the completion of an IPO. This ranking, since updated by Jay Ritter, is much used in the empirical IPO literature. Megginson and Weiss (1991) measure underwriters’ reputation instead by their market share, and this approach is also widely used.

A specific way to reduce the informational asymmetry is to hire a prestigious underwriter or a reputable auditor. By agreeing to be associated with an offering, prestigious intermediaries "certify" the quality of the issue. Investors incur no cost in becoming informed.

If information production is costly, underwriters need to decide how much information production to induce. Sherman and Titman (2002) explore this question in a setting where more information increases the accuracy of price discovery, resulting in a trade-of between the (issuer-specific) benefit of greater pricing accuracy and the cost of more information production.

Underwriters can reduce the required extent of underpricing if the issuer has a credible option to withdraw the offering. Downplaying positive information increases the likelihood that the issuer will withdraw, which reduces an investor’s gain from misrepresenting positive information.